This article is reprinted from the October 2009 issue of the Exchange-Traded Funds Report.

Investors with a penchant for commodities have three distinct choices when it comes to picking ETFs; they are, in increasing order of complexity and idiosyncrasy, as follows:

• ETFs that hold equities related to a commodity
• ETFs that hold the physical commodity in trust
• ETFs that hold futures contracts on a commodity

Equity ETFs

Considering equity ETFs is really cheating, and yet many investors naturally turn to equity ETFs because they are familiar. Funds like Van Eck Global’s Market Vectors Gold Miners ETF (NYSEArca: GDX) sound like a great idea. After all, what better way to play gold than to buy gold miners? The problem is that pick-and-shovel commodities companies aren’t always well correlated to their underlying commodities. GDX, for example, has only a 0.77 correlation to the actual price of gold in the two years prior ending Sept. 1, 2009. Still, in some cases (coal, uranium, steel), the pick-and-shovel ETFs are the only way to get any exposure to markets that are otherwise too illiquid, or too difficult to access for individual investors, like steel.

Physical ETFs

Physical ETFs are also easy to understand. The SPDR Gold Trust (NYSEArca: GLD), for example, works like an experienced ETF investor might expect—it holds gold in a vault. New shares are created when an authorized participant delivers gold bars to the vault, and ETF shareholders own an interest in some fractional amount of 400 oz. gold bars. These funds are the exception in the commodities space, however, and currently only available for gold, silver and (outside the U.S.) platinum. The reason is simple: Precious metals are the only commodities where the storage costs are minimal, and the spot market liquid enough to support physical holdings changes on a daily basis.

Physical ETFs have a few quirks. While they are generally efficient vehicles, whether they are the most efficient way to own, say, gold bullion, is a subject of some debate. Major investors such as David Einhorn’s Greenlight Capital hedge fund have publicly made the move out of physical ETFs in favor of simply buying bullion and paying for storage. For small investors, however, the convenience of buying by the share and paying a brokerage commission outweighs these edge-case arguments.

The second quirk is taxes. Investors in bullion-based ETFs are taxed as if they owned the bullion itself—as collectors. The current tax on precious metals profits is 28%, no matter how long you hold (vs. a 15% long-term capital gains rate on equity-based ETFs).

Futures-based ETFs represent the bulk of commodity ETF offerings, and for good reason. Most of the trading in the world’s most important commodities—corn, oil, natural gas, sugar, soybeans, etc.—takes place not in physical trading, but on the futures exchanges.

The futures markets were created specifically for commodities, dating back to the grain markets of the Midwest in the 1800s. Then, like now, farmers wanted to lock in their prices for the coming harvest, and the big buyers of those crops liked knowing what their costs would be for the coming year. Futures provide the solution for both the buyer and the seller. Simply put, a future is a promise to buy (or sell) a product for a specific price at a specific date in the future. And while most futures contracts can result in the physical delivery of corn or oil or greasy wool, the majority of futures contracts traded on exchanges are simply settled for cash or sold before they expire. This means investors can participate in these markets without having warehouses or underground natural gas facilities.

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